Muni's Are Still Attractive

By Aaron Levitt | February 02, 2012 AAA

Despite all the dire predictions, the municipal bond market continues to impress. As the low interest rate environment continues to persist, investors have been drawn to anything with some semblance of a yield. To that end, yields on muni bonds continue to drop and recently touched a 44-year low. As a whole, municipal bonds throughout 2011 outperformed almost every major bond category and even U.S. stocks. While most of capital gain component of the formerly "sleepy" securities is probably finished, the Fed's recent announcement that it plans to keep rates low until 2014, bodes well for the bond's tax -ree yields. For investors, muni's still have appeal going forward. (For related reading, see The Basics Of Municipal Bonds.)

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Improving Conditions
During 2010 and the beginning part of 2011, worries about the state of public finance saw a wave of analysts predicting huge defaults across the municipal bond spectrum. Perhaps the most detrimental to the sector was credit analyst Meredith Whitney, who became famous by predicting Citigroup's (NYSE:C) dividend cut. Whitney predicted "hundreds of billions of dollars" of municipal defaults on the TV show "60 Minutes." In addition, the expiring Build America Bond program had created a supply glut of new issues. These analysts' predictions coupled with the overabundance of supply resulted in panic-selling and the average long-term muni fund fell by 7.3%.

What a difference a year makes. The defaults didn't materialize and economic conditions continue to improve. Overall, $3.7 trillion municipal-bond market returned an impressive 11.2% in 2011. While most analysts estimate that the sector won't see those kinds of gains in 2012, the security still has great appeal for portfolios. As interest rates hover never zero, demand for munis continues to outstrip supply. Even with analyst predictions that new issuance will increase by about 15% this year.

And those tax free coupon payments could be worth more in the years ahead. At year's end, the Bush-era tax cuts will expire and more investors will find themselves in higher tax brackets. This makes muni's current valuations a bargain. A 10-year AAA rated municipal bond currently pays around 1.9%, roughly what a 10-year treasury pays. However, due to the muni's tax free nature, that yield is worth a lot more. The treasury would have to pay around 2.6% for someone in 28% tax bracket to be a better deal. Moving slightly down the credit spectrum and muni tax free yields are better than high grade corporate bonds. (To learn more, check out how to Avoid Tricky Tax Issues On Municipal Bonds.)

Playing Those Juicy Tax-Free Yields
For investors in the 28 and 35% tax brackets, municipal bonds are still an attractive bet and the ETF boom has made adding them easy. The behemoth in the sector is the iShares S&P National AMT-Free Muni Bond (ARCA:MUB) with more than $2.6 billion in assets. The fund currently yields around a tax-free 3.25% and tracks about 1,771 muni bonds. The fund was a major beneficiary of the interest in the sector, receiving more than $370 million in new investor money in 2011. For investors looking for a more active touch, the PIMCO Intermediate Muni Bond Strategy (ARCA:MUNI) could used. The fund is currently focusing on "quality" versus yield and could be a good bet if the rally continues.

However, some of best and strongest yields can be had in closed-end funds. The closed-end funds use of leverage causes many to yield around 6.5%; that's a 10% tax free yield for someone in the 35% tax bracket. The Nuveen Municipal Value Fund (NYSE:NUV) currently can be had for around its net asset value (NAV), but yields a taxable equivalent yield of approximately 7.14%. Similarly, investors in high-tax states like California and New York can find muni closed-end funds that trade at NAV discounts with juicy yields, such as the BlackRock MuniYield NY Quality (NYSE:MYN) and INVESCO Cali Muni Securities (NYSE:ICS). For those looking for a broad approach to muni closed-end funds, the new Market Vectors CEF Municipal Income (ARCA:XMPT) tracks a basket of municipal CEFs, offering investors a chance to own a wide swath of bonds with different management styles.

The Bottom Line
Despite the dire predictions, the municipal bond sector is seeing great returns. However, bonds in the sector continue to offer value for those investors in higher tax brackets. The previous funds, along with the SPDR Nuveen Barclays Capital Muni Bond (ARCA:TFI) make ideal selections to play the sectors still relatively-high tax-free yields. (For additional reading, see Taxation Rules For Bond Investors.)

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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.

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